Real Money

Mortgage REITs' Acid Test: Street Whispers

Lower dividends and analyst disagreement about Q3 earnings prospects.

NEW YORK ( TheStreet) --Mortgage REITs were having a brilliant year in 2012, but ran into a brick wall some three weeks ago, and there is some disagreement among analysts over whether the sector will redeem itself when companies report third quarter earnings.

From the start of the year through Sept. 21, Market Vectors ETF Trust ( MORT), a mortgage REIT exchange traded fund, gained 23.87%, not counting its sizeable dividend yield (currently just below 10%). From Sept. 24 through Thursday, however, the fund has fallen 5.5% on worries over shrinking dividends.

Some commentators have pinned the blame on QE3--specifically, the Federal Reserve's Sept. 13 announcement that it would buy long-dated mortgage backed securities in an effort to stimulate home purchases by lowering the mortgage rate for prospective new homebuyers.

Mortgage REITs use leverage to buy mortgage backed securities (MBS) and profit on the spread between the dividend income and their (relatively lower) cost of raising money to buy more MBS. Lower yields on long-dated MBS means rising book values for mortgage REITs because the MBS they own rise in value. However, the lower long term yields mean that when MBS mature, the mortgage REITs must reinvest their earnings at lower yields.

Further, mortgage REITs face a rising risk of prepayment as homeowners pay off mortgages in order to refinance at lower rates.

However, Sterne Agee analyst Jason Weaver argues in a report published Thursday these risks "have been apparent for some time, thus we find it unlikely to be the driver of recent sector weakness as commonly cited." Rather, Weaver attributes the recent selloff to investors pocketing gains and reallocating money to sectors that haven't performed as well.

Weaver, on the other hand, does not share those concerns. He sees "a good possibility of significant upside surprises" on earnings and book value, particularly for American Capital Agency Corp. He did not address Annaly or CYS in his report.